Monday, May 9, 2011

Hussman Weekly Market Comment: The Menu

"The reality of risk is much less simple and straightforward than the perception. People vastly overestimate their ability to recognize risk and underestimate what it takes to avoid it; thus, they accept risk unknowingly and in so doing contribute to its creation.

"Risk arises as investor behavior alters the market. Investors bid up assets, accelerating into the present appreciation that otherwise would have occurred in the future, and thus lowering prospective returns. And as their psychology strengthens and they become bolder and less worried, investors cease to demand adequate risk premiums. The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it.

"People often say, 'It's not cheap, but I think it'll keep going up because of excess liquidity (or any number of other reasons). In other words, they say, 'It's fully priced, but I think it'll become more so.' Buying or holding on that basis is extremely chancy, but that's what makes bubbles. In bubbles, infatuation with market momentum takes over from any notion of value and fair price, and greed (plus the pain of standing by as others make seemingly easy money) neutralizes any prudence that might otherwise hold sway."

Howard Marks, The Most Important Thing

Just a note - Howard Marks is the head of Oaktree Capital Management, and wrote his new book, The Most Important Thing at the behest of Warren Buffett. Though the bulk of Oaktree's business is in high yield debt, distressed debt, and private equity, the book is packed with insightful lessons for investors in most other markets as well. Included are many quotes from Marks' client letters over the years. If you read them carefully with attention to their dates, you'll notice that a great many of them would have been largely dismissed by investors because they were warnings against ongoing speculation - both in the late 1990's and in the 2004-2007 period. Though Marks' focus on value and risk management leaves little room for other quantitative investment methods and tools that I believe are useful - particularly those based on market action, internals and trend-sensitive indicators - I am convinced that most trend-followers pay far too little respect to value and true risk management (apart from, say, selling when prices break some moving average), so this book will be a great benefit to quantitative and technical investors as well.

You won't find much in the way of specific models or methods, but the perspectives on value, risk and prospective return are outstanding. For long-term readers of my own market comments, you'll see a lot of familiar themes. Marks views the ultimate investment error as "reaching for return" when markets are not priced to deliver them, and quotes Peter Bernstein, who said "The market's not a very accommodating machine; it won't provide high returns just because you need them."


Related book: The Most Important Thing